A. 1) What is meant by the term “distribution policy”? How have dividend payout versus stock repurchase changed over time? Distribution Policy involves three issues. 1) What fraction of earnings should be distributed? 2) Should the distribution be in the form of cash dividends or stock repurchases? 2) Should the firms maintain a steady, stable divided growth rate? The dividend payout versus stock repurchase has changed dramatically during the past 30 years. First off the total cash distributions as a percentage of net income have remained the same fairly stable at around 26% to 28%, but the mix of dividends and repurchases has changed. The average dividend payout fell from 22.3% in 1974 to 13.8% in 1998, while the average repurchase payouts as a percentage of net income rose from 3.7% to 13.6%. Since 1985, large companies have repurchased more shares than they have issued. Ever since 1998, more cash has been returned to shareholders in repurchases then as dividend payouts. Second, companies today are less likely to pay a dividend. In 1978, about 66.5% of NYSE, AMEX, and Nasdaq firms paid a dividend. In 1999, only 20.8% paid a dividend. A portion of this reduction can be explained by the larger number of IPO’s in the 1990’s, since young firms rarely pay a dividend. Even though that doesn’t explain the whole story, as many mature firms now don’t pay dividends. Third is that relatively small number of older, more established, and more profitable firms accounts for most of the cash distributed as dividends and finally there is a considerable variation in distribution policies, as some companies pay a high percentage of their income as dividends and some pay none.

2) The terms “irrelevance,” and “dividend preference, or bird-in-the-hand,” and “tax effects” have been used to describe three major theories regarding the way dividend payout affect a firm’s value. Explain what these terms mean, and briefly describe each theory.

Irrelevance theory was created by two men which names are Merton Miller and Franco Modigliani. They argued that the firm’s value is determined by its basic earning power and its business risk. Basically the firms depends on the income produced by its assets not on how income is split between dividend and retained earnings. To understand this theory better any shareholder can construct its own dividend policy. An example if a firm does not pay dividends and a shareholder that want to a 5% dividend can create it by selling 5% of his stock. So if investors could buy and sell their own shares and plus create their own dividend policy without incurring cost then it would truly be irrelevant.

Dividend Preference Theory that was created by Myron Gordon and John Linter argue that a stocks risk declines as dividends increase, in other words a bird in the hand is worth more than a bird in the bush meaning that’s its better receive cash in your hands from dividend than rather letting it go to the market. That’s why shareholders wand dividends and are willing to accept a lower required return on equity.

The Tax Effect Theory argues that are two reasons why stock price appreciates still is taxed more favorably than dividend income. First, due to time value effects, a dollar of taxes paid in the future has a lower effective cost than a dollar paid today. So if dividend and gains are taxed the same, capital gains are never taxed sooner than dividends. Second, if a stock is held by someone until he or she dies, no capital gains tax is due at all, the beneficiaries who receive the stock can use the stock’s value on the death day as their cost basis and thus completely escape the capital gains tax.

3) What do the three theories indicate regarding the actions management should take with respect to dividend payouts? What the three theories indicate regarding the...

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